Financial Services Alert - September 7, 2010

The SEC recently adopted amendments to the proxy rules under the Securities Exchange Act of 1934 (the “1934 Act”) that facilitate shareholder nomination of directors.  The release adopting the amendments is available here.  The amendments also revise Rule 14a-8 under the 1934 Act, principally to eliminate an issuer’s ability to exclude a shareholder proposal that relates to a procedure for the nomination or election of directors under Rule 14a-8(i)(8) and to codify prior SEC staff positions regarding an issuer’s ability to exclude certain shareholder proposals relating to director elections.  This article summarizes the main features of the SEC’s amendments to the proxy rules, which include several features specific to registered investment companies.

Shareholder Nominations.  New Rule 14a-11 under the 1934 Act requires an issuer to include a shareholder nominee or nominees for director in an issuer’s proxy statement and form of proxy (collectively, “proxy materials”) if certain conditions are met.  The rule applies to all issuers subject to the proxy rules, including investment companies, except for issuers subject to the proxy rules solely because they have a class of debt registered under Section 12 of the 1934 Act. 

Shareholder Nominations Prohibited by State or Foreign Law/Governing Documents.  Rule 14a-11 does not apply if state or foreign law or an issuer’s governing documents prohibit shareholders from nominating directors.  (The release adopting the amendments notes that the SEC is unaware of any such state law.  If an issuer’s governing documents prohibit shareholder nominations, under the amendments to Rule 14a-8 discussed below, a shareholder may submit a proposal to remove the prohibition for inclusion in the issuer’s proxy materials.)  State or foreign law or an issuer’s governing documents could provide for rights in addition to those contained in the amendments, i.e., they could allow an issuer to include in its proxy materials nominees put forward by shareholders who would not be eligible to rely on Rule 14a-11.  An issuer may not opt out of Rule 14a-11 by adopting alternate requirements for inclusion of shareholder nominees in its proxy materials.

Shareholder Eligibility.  Under Rule 14a-11, a shareholder wishing to nominate a director or directors for inclusion in an issuer’s proxy materials must meet a minimum ownership threshold with respect to the issuer’s voting securities that involves requirements as to the amount of securities held, the holder’s investment and voting power over those securities and how long the securities have been held.  A nominating shareholder relying on Rule 14a‑11 may not own the issuer’s securities with the purpose or effect of changing control of the issuer or to gain seats on the issuer’s board in excess of the maximum number of shareholder nominees required under Rule 14a-11.

To be eligible to have a nominee included in an issuer’s proxy materials, a nominating shareholder must own securities representing at least 3 percent of the votes entitled to be cast at the meeting for the election of directors.  The percentage owned is determined as of the time the shareholder files the required notice on new Schedule 14N regarding the nomination, as discussed below.  Under certain conditions, loaned securities may be counted toward the ownership threshold while certain securities sold short or borrowed for purposes other than short sales must be excluded.

A nominating shareholder must hold both voting and investment power over the securities representing the requisite voting power.  If a company has multiple classes of stock that do not vote together in the election of all directors (where, for example, each class elects a subset of directors), then voting power is determined only on the basis of the voting power of the class or classes of stock that vote together on the election of the person or persons sought to be nominated by the nominating shareholder, rather than the voting power of all classes of stock. 

In addition, a nominating shareholder relying on Rule 14a-11 is required to have held the qualifying amount of voting securities continuously for three years prior to submitting the required notice on Schedule 14N relating to the nomination.  Shareholders may aggregate holdings to meet applicable thresholds by forming a shareholder group.  (As a consequence, when this article refers to a nominating shareholder, it should also generally be read to refer to a nominating shareholder group.)

In the case of a registered investment company, other than a series company, the 3 percent ownership threshold is calculated based on the issuer’s voting securities disclosed in the issuer’s most recent annual or semi-annual report filed on Form N-CSR.  Because their series may not share the same fiscal year end, series investment companies must provide information for determining the share ownership threshold by filing Form 8-K within four business days after determining the anticipated shareholder meeting date.  The Form 8-K filing must disclose a series investment company’s total number of shares entitled to vote for the election of directors at the meeting (or if the votes are to be cast on a basis other than one vote per share, then the total number of votes entitled to be voted and the basis for allocating them) as of the end of the most recent calendar quarter.

Schedule 14N.  A shareholder must provide the issuer and the SEC with a notice on Schedule 14N in order to nominate a director in reliance on Rule 14a-11.  The Schedule 14N filing includes disclosure about the amount and percentage of securities owned by the nominating shareholder and length of ownership, and the nominating shareholder must certify, among other things, that (a) the nominating shareholder intends to continue to hold the securities through the date of the meeting, (b) the nominating shareholder does not hold the company’s securities with the purpose or effect of changing control of the company or to gain seats on the board in excess of the maximum number of shareholder nominees that Rule 14a-11 requires be included in the company’s proxy materials and (c) each shareholder nominee satisfies the requirements of Rule 14a-11.  The nominating shareholder must make a statement in Schedule 14N regarding its intent with respect to continued ownership after the election.  The Schedule 14N must also provide disclosure for use in the issuer’s proxy materials similar to that currently required under the proxy rules for contested elections and disclosure regarding the nature and extent of the relationships between the nominating shareholder and nominee and the company or any affiliate of the company.  A nominating shareholder may provide a statement in support of its nominee(s), not to exceed 500 words for each nominee. 

A nominating shareholder must promptly amend its Schedule 14N for any material change with respect to a nomination, or in the disclosure or certifications in a prior notice.  Within 10 calendar days after the announcement of an election’s final results, a nominating shareholder must file an amendment on Schedule 14N that states the nominating shareholder’s intention with respect to continued ownership of the company’s shares.

A nominating shareholder relying on Rule 14a-11 is liable for any false or misleading statements in disclosures made in connection with a nomination under Rule 14a-11, regardless of whether such information is included in the issuer’s proxy materials.  The amendments provide that an issuer will not be responsible for information provided by a nominating shareholder that is included in the issuer’s proxy materials.  Information provided by a nominating shareholder in its notice on Schedule 14N and then included by an issuer in its proxy materials will not be incorporated by reference into any filing by the issuer under the Securities Act of 1933, the 1934 Act or the Investment Company Act of 1940 unless the issuer determines specifically to do so.

A nominating shareholder is required to file Schedule 14N with the issuer and the SEC no earlier than 150 calendar days and no later than 120 calendar days before the date that the issuer mailed its proxy materials for the prior year’s annual meeting.  If the issuer did not hold an annual meeting during the prior year, or if the date of the meeting changed by more than 30 days from the prior year, then the nominating shareholder must provide its notice on Schedule 14N by the deadline specified by the issuer in a Form 8-K filed within four business days after the issuer determines the anticipated meeting date, which deadline must be a reasonable time before the issuer intends to mail its proxy materials for the meeting.

Shareholder Nominees.  An issuer is not required to include a shareholder nominee in its proxy materials if the nominee’s candidacy or membership on the board would violate applicable state law, federal law or the applicable rules of a national securities exchange or national securities association (other than those relating to director independence), and the violation could not be cured as provided in Rule 14a-11.  For an issuer other than a registered investment company, a shareholder nominee must also meet the objective independence standards of the relevant national securities exchange or securities association that apply to directors generally (but not to any particular definition of independence applicable to audit committee members); a nominee is not be required to meet an independence standard that requires a subjective determination by the issuer’s board, e.g., regarding the existence of factors material to the determination of a nominee’s independence.  In the case of a registered investment company, a nominee meets Rule 14a-11’s independence standard if the director nominee is not an “interested person” of the issuer within the meaning of the Investment Company Act of 1940.

Neither the nominating shareholder nor the nominee may have a direct or indirect agreement with the company regarding the nominee’s nomination.  Rule 14a-11 does not provide a safe harbor from the definition of “affiliate” under the Securities Act of 1933 for persons who may be affiliates of the issuer as result of having made a director nomination, under Rule 14a‑11 or otherwise.  The adopting release notes that shareholders nominating directors will need to analyze affiliate status on a case-by-case basis.

Number of Shareholder Nominees.  Under the amendments, an issuer is required to include in its proxy materials no more than one shareholder nominee, or the number of nominees that represents up to 25 percent of the issuer’s board of directors, whichever is greater.  Any currently serving directors elected through the Rule 14a-11 mechanism whose term extends past the election in question is counted towards the limit.  For issuers with classified (staggered) boards, the 25 percent calculation is based on the total number of board seats.  If a company has multiple classes of securities and each class is entitled to elect a specified number of directors, the company is required to include the lesser of the number of nominees that the nominating shareholder’s class is entitled to elect or 25% of the company’s board of directors, but in no case less than one nominee.  If a company agrees to include as an unopposed nominee of the company a shareholder nominee who otherwise would be eligible under Rule 14a-11 and the nominating shareholder filed Schedule 14N before beginning communications with the registrant about the nomination, the nominee will be considered a shareholder nominee for purposes of calculating the maximum number of shareholder nominees.  A shareholder nominee included in the company’s proxy materials as a result of an agreement reached with the nominee or nominating shareholder under any other circumstances is not counted as a shareholder nominee when calculating the shareholder nominee maximum.  If an issuer receives multiple shareholder nominations meeting the requirements of Rule 14a-11, the issuer will determine which to include in its proxy materials following an order of precedence based on the percentage of the issuer’s voting securities held, rather than one based on order of receipt as originally proposed.

Inclusion/Exclusion of Shareholder Nominees in Issuer Proxy Materials.  Under the amendments, in the absence of any grounds for excluding a shareholder nomination, an issuer is required to include in its proxy materials disclosure regarding the nominee and, if provided by the nominating shareholder, a statement in support of the nominee.  In its form of proxy, an issuer may identify any shareholder nominees as such and recommend on the form of proxy how shareholders should vote on those nominees and on management nominees, but is otherwise required to present the nominees in an impartial manner in accordance with Rule 14a-4 under the 1934 Act.  An issuer may not allow shareholders to vote for, or withholding authority to vote for, nominees as a group, but instead must require that each nominee be voted on separately.

The amendments include the following grounds for exclusion of a shareholder nominee:

• Rule 14a-11 is not applicable to the issuer;
• The nominating shareholder or nominee failed to satisfy the eligibility requirements of Rule 14a-11; or
• The issuer has already reached the maximum number of shareholder nominees required to be included in its proxy materials.

The amendments set forth procedures regarding the eligibility determination for a shareholder nomination and various notifications and responses to be provided to and by issuers and nominating shareholders, and by the issuer and nominating shareholders to the SEC, all within prescribed timeframes.  These procedures allow a nominating shareholder 14 calendar days to cure (if curable) a deficiency identified by the issuer in its notice to the nominating shareholder regarding the issuer’s decision to exclude a shareholder nominee.  A shareholder nominee may not change the shareholder’s nominee or the composition of the nominating shareholder group to cure a deficiency identified by the issuer.  However, if a nominating shareholder submits a number of nominees that exceeds the maximum number required to be included in the company’s proxy materials under Rule 14a-11, the nominating shareholder may specify which nominee or nominees are not to be included in the registrant’s proxy materials.  Similar to the process followed under Rule 14a-8 regarding shareholder proposals, an issuer may seek no-action guidance from the SEC staff regarding exclusion of a shareholder nomination.  With some exceptions, the burden is generally on the issuer to demonstrate that it may exclude a shareholder nominee.

Communications Related to Shareholder Nominations.  The amendments create additional exemptions from the proxy rules’ prohibition against solicitations prior to the filing and dissemination of a proxy statement.  In order to facilitate the use of Rule 14a-11 and remove concerns regarding communications among shareholders regarding the submission of a nomination, the SEC adopted an exemption that applies to communications—including oral communications—meeting specific content limitations.  The SEC also adopted an exemption for solicitations by or on behalf of a nominating shareholder in support of a nominee included in an issuer’s proxy materials.  The exemption includes limitations on the content of the solicitation and provides that the soliciting party may not directly or indirectly seek the power to act as proxy.  Communications pursuant to these exemptions must be filed with the SEC no later than the date such communications are first disseminated.  Solicitation activity related to director elections outside the scope of these new exemptions generally forecloses reliance on them.

Shareholder Proposals.  Rule 14a-8 under the 1934 Act provides shareholders with an opportunity to place a proposal in an issuer’s proxy materials for consideration at an annual or special meeting of shareholders.  If a shareholder proposal meets certain procedural requirements and does not fall within one of the categories of proposals that the Rule allows an issuer to exclude, the proposal must appear alongside management’s proposals in the issuer’s proxy materials.  Prior to the amendments, Rule 14a-8(i)(8) under the 1934 Act permitted an issuer to exclude a shareholder proposal relating to a nomination or an election for membership on the issuer’s board of directors or analogous governing body or a procedure for such nomination or election.  Under the amendments, a company may no longer rely on Rule 14a-8(i)(8) to exclude a shareholder proposal that seeks to establish a procedure in a company’s governing documents for including one or more shareholder nominees for director in the company’s proxy materials.  The amendments also codify prior SEC staff interpretations regarding shareholder proposals that will continue to be excludable under Rule 14a-8(i)(8), such as those that (a) would disqualify a nominee who is standing for election, (b) would remove a director from office before the director’s term expired, (c) question the competence, business judgment, or character of one or more nominees or directors, or (d) otherwise could affect the outcome of an upcoming election of directors.

Shareholder Nominees Pursuant to State or Foreign Law or an Issuer’s Governing Documents.  State or foreign law or an issuer’s governing documents may permit shareholder nomination of directors.  In addition, as amended, Rule 14a‑8(i)(8) permits amendments to an issuer’s nomination procedures to allow shareholder nominations without reliance on Rule 14a-11.  Nominating shareholders acting pursuant to procedures established by state or foreign law or under an issuer’s governing documents must file a notice on Schedule 14N with the issuer and the SEC.

Shareholder Groups.  The amendments provide that a nominating shareholder’s activities related to reliance on Rule 14a-11 will not affect the shareholder’s eligibility to satisfy its Section 13 reporting obligations using Schedule 13G.  This provision does not apply to a nominating shareholder relying on state or foreign law, or a company’s governing documents.

Effective/Compliance Date.  The amendments will be effective 60 days after publication in the Federal Register.  Compliance with the amendments is required beginning on the effective date except for companies that as of the effective date are “smaller reporting companies” as defined in Rule 12b-2 under the 1934 Act, which will be subject to Rule 14a‑11 beginning three years after the effective date.

Goodwin Procter’s M&A/Corporate Governance Practice has issued a Client Alert that examines the recent SEC rule changes designed to facilitate shareholder nomination of directors and their immediate implications for public companies.  The Client Alert is available here.

The Financial Crimes Enforcement Network (“FinCEN”) announced the assessment of a $50,000 civil money against Pinnacle Capital Markets, LLC (“Pinnacle”), an SEC‑registered broker-dealer, for violations of the Bank Secrecy Act (“BSA”) and the regulations thereunder.  FinCEN assessed the civil money penalty based on what it determined were systemic violations of the anti-money laundering (“AML”) and suspicious activity reporting requirements of the BSA and its implementing regulations by Pinnacle between October 2002 and September 2009. 

Pinnacle’s core business consists of providing foreign individuals and institutions access to securities markets in the United States, allowing those customers, using market access software, to have direct control over accounts and direct access to U.S. securities markets through omnibus accounts.  FinCEN noted that Pinnacle’s business model and customer base present uncommon risks that needed to be identified and managed by Pinnacle for potential misuse by customers.  FinCEN determined that, although Pinnacle received AML procedures from a third party consultant, Pinnacle failed to appropriately modify the AML compliance program to reflect the risks presented by Pinnacle’s business model.

Pinnacle’s AML compliance deficiencies included the failure to properly apply its customer identification program (“CIP”) to certain foreign customers.  In particular, many foreign customers accessed Pinnacle’s services as sub-account holders to foreign financial institutions that held master accounts with Pinnacle.  Although FinCEN and the SEC have issued guidance which states that, in certain circumstances, broker-dealers do not need to look through omnibus accounts when applying their CIPs, FinCEN clarified that such guidance applies only when all transactions in the omnibus account are initiated by the financial intermediary and the beneficial owner has no direct control over the omnibus account.  By contrast, the sub-account holders in Pinnacle’s case were “customers’ of Pinnacle because they were able to directly transmit orders to Pinnacle.  Accordingly, FinCEN stated that Pinnacle must apply its CIP to these sub-account holders. 

In addition to these CIP violations, FinCEN concluded that Pinnacle failed to establish and implement risk-based due diligence procedures for correspondent accounts, despite the fact that, during the relevant period, nearly half of Pinnacle’s fully-disclosed customers resided in locations identified in the U.S. Department’s International Narcotics Control Strategy Report (“INCSR”) as Jurisdictions of Primary Concern and half resided in Jurisdictions of Concern.  Similarly, FinCEN’s order points out that of 92 foreign financial institutions with correspondent accounts at Pinnacle, nearly half were domiciled in Jurisdictions of Primary Concern and half were domiciled in Jurisdictions of Concern.  Jurisdictions of Primary Concern, according to the INCSR, are countries whose financial institutions engage in currency transactions involving significant amounts of proceeds from international narcotics trafficking.  Consequently, jurisdictions with high levels of financial activity are more likely to be Jurisdictions of Primary Concern.  The list includes Canada, Brazil, France, Germany, Spain, Switzerland, the U.K. and the U.S.  FinCEN also determined that the ineffectiveness of Pinnacle’s manual transaction monitoring system resulted in the failure to file suspicious activity reports (“SARs”) involving millions of dollars in transactions and a SAR failure to file rate of 29%.  More generally, Pinnacle failed to meet independent testing and AML training requirements at certain points during the relevant time period.

FinCEN conducted its investigation of Pinnacle in cooperation with the SEC and FINRA.  The $50,000 civil money penalty, which includes a concurrent assessment of $25,000 by the SEC for violations of Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-8 thereunder, will be satisfied by two payments to the U.S. Treasury Department.